Regulation: No guesswork, no crystal balls
11 September 2019
This article was originally published in the Multi-Asset Review.
When it all gets a bit too much and there are way too many trees to allow a proper view of the wood, I always consult with the lovely and long-suffering Mrs Donaldson.
Take the contribution you have just started reading: I was going to write about regulation, new and old, and how the Retail Distribution Review (RDR) and the second iteration of the Markets in Financial Instruments Directive (MiFID II) have changed the way we work - and, in particular, how we look after our clients' investment portfolios.
New rules and guidance
There seems to be a never-ending flow of new rules and guidance. Suitability, cost, transparency, governance, replacement business, conflict of interests, due diligence requirements and shoe-horning - all appear to be new and adding to the complexity of client portfolio management. Throw into the mix investment platforms and now ‘son of platform' robo-advice and you are still only scratching the surface ... Oh dear, where to start?
So I showed Mrs D the list, told her to pretend to be a client and asked: "Where do I start?" She then ‘advised' me. "Personally," she said, "I am interested in knowing if what I have invested in is suitable for me and at a fair cost. All the rest is down to you to worry about, understand and ensure is in order - after all that is what you get paid for." So I thought that was it - but apparently it was not...
"What I am interested in is how you make sure that what you invest in is suitable for me," Mrs Donaldson continued. "Not very interested but enough to want to know that it isn't all guesswork and crystal balls." Now that did get me thinking and the best I could come up with was good diversification. "Tell me more," she said. I'm on to something here, I thought.
So, I told her that suitability is about understanding your requirements and diversification is the tool required to structure an appropriate portfolio in terms of the amount of risk you would be comfortable in taking. "Go on," she said, so I started talking about multi-asset investment and achieving the right amount of correlation between the different types of assets.
At this point, however, her eyes glazed over and she asked what language I was speaking in. I told her it was a massive simplification but what I meant was ‘Don't put all your eggs in one basket'. "Then why didn't you say so?" she sighed, and went off to watch Corrie.
So, potentially, that is where a client's interest may end. Feeling like Mrs D had once again given me a much-needed sense of perspective, and feeling just a little pleased I had boiled down the recommendation of a client portfolio to just two words - suitability and diversity - I thought on.
Suitability – the key to successful outcomes
Suitability of course has innumerable sub-categories, all of which need to be covered with the client. Included here would be understanding the client's objectives, tax implications, the risk the client is willing to take, the cost (or, more accurately, value for money), management of conflicts of interest and, in the case of replacement business, sound justification.
Still, not such a long list, and barely a mention of MiFID II and RDR. So it occurs to me there is nothing new in the investment process - just a lot more rules, guidance and regulation that remind us all how it should be done.
Diversification – controller of risk
I mentioned diversification earlier and it is worth taking a closer look. To my mind, it is the main tool - possibly the only tool - to be used when structuring a client's portfolio. Diversification per se, in a ‘don't put all your eggs in one basket' sense, is just a sensible thing to do.
This wisdom of the ages is probably most relevant when considering unsystematic risk - that something goes wrong that is specific to that one holding or stock, but unlikely to affect any others. In simple terms, that would mean investing in two oil stocks just in case one of them has a major oil spill and goes bankrupt paying all its liabilities.
There is also the kind of diversification that is employed as a more targeted tool and is used to adjust the risk/return trade-off. This is the consideration and management of systematic risk, or market risk, which refers to events or uncertainty that can affect multiple assets.
A recession, for example, will affect many industries and, as recessions can be global, many economies can be affected. Crucially though, usually not all assets are correlated in terms of reaction to a market cycle. A fall in equity markets may not necessarily mean a commensurate drop in property prices or the returns on fixed interest stock.
Other asset types may behave differently, such as commodity prices. Sometimes commodity prices are a sign of a coming recession as demand falls but, equally, price rises may be a sign of the return of a healthier economy.
Money can be made by hedge fund techniques such as ‘shorting' - betting one currency against another or one stock market against another. As the terminology suggests, these would be a riskier investment.
Due diligence – be sure of the portfolio managers approach
It is more difficult to eliminate systematic risk, as most asset types are correlated to some extent. The risk profiles of different asset types can, however, have different levels of correlation. It should also be remembered that correlations can be transitory, so it is important they are monitored and checked on a regular basis.
As such, it is crucial that advisers check what a portfolio manager's approach to diversification, risk and asset correlation entails - and importantly, when it is a fund of funds, whether the manager applies his diversification philosophy to the underlying collectives.
So ‘just' suitability and diversification then. No, it is not easy and there are many subtleties and issues to be considered. That said, none of this is new either and we must not forget that, to a greater or lesser extent, we have always approached a client's portfolio this way. There is just quite a lot more regulatory reporting required...
You might be also interested in other Insight articles.